Bank Capital Adequacy versus Deposit Insurance

This paper re-evaluates the Diamond-Dybvig analysis of deposit insurance by constructing a model in which an agent not in need of liquidity sets up a financial intermediary to sell liquidity insurance to other agents who desire such insurance. This intermediary resembles a real-world bank in that it is financed by both demand deposits and equity. It also dominates the Diamond-Dybvig intermediary, which is funded only by demand deposits. Provided the intermediary has adequate capital, it also is perfectly safe. Deposit insurance then is both unnecessary and incapable of achieving a superior outcome to that which private agents could achieve on their own.